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A Deep Freeze for Options

August 12, 2001

This from the would-you-believe department: The stock market is no longer volatile. If you're skeptical, just ask the pros who bet money on how volatile the markets will be. Their favorite measure, the CBOE Volatility Index traded on the Chicago Board Options Exchange, or VIX, has fallen 40% after peaking on Mar. 22--the highest level since October, 1998, when Long-Term Capital Management's debacle sent markets spinning (table). The CBOE's Nasdaq Volatility Index, or VXN, has also plunged.

What gives? It's not as though the market has suddenly become an ocean of calm. Sure, the summer lull is upon us, but the reasons for the decline run deeper. Low volatility is the aftermath of a market run amok during the tech boom and bust. Day traders are on the endangered species list, and hedge-fund managers no longer use options to lock in gains because they have few gains to protect. "The people used to pursuing the riskiest strategy and leveraging for the most speculative Internet stocks are now into safer stocks, bonds, and cash," says Leon Gross, Salomon Smith Barney's global head of equity derivative research.

A TAME BEAST. By some measures, the market looks as if it's gyrating more than ever. According to researcher the Leuthold Group, the Nasdaq moves up or down 1% about three out of every four trading days, while the Standard & Poor's 500-stock index makes 1% moves every other day--both sharp increases since 1995. That sounds like volatility to most people. Trouble is, Leuthold's model doesn't exclude stocks that, say, routinely rise or fall by 1%, or move in other predictable patterns.

To the markets, it's unpredictability that translates into the volatility that pros need to make money. Current low volatility has put the market for options on stocks in a deep freeze. Options buyers need big swings in stock prices to increase their chances of making a profit after paying a premium to buy an option to buy or sell a stock at some future date. Last year, premiums were high, reflecting that the odds for gains were, too. "You're hoping for a lot of volatility, because the only way you get paid is through movement in the underlying stock," says Ken Nakayama, chief equity derivatives strategist for Deutsche Bank.

The volatility crunch has hammered options traders with losses and threatened to put them out of business. Paul G. Foster, equity strategist at 1010WallStreet.com, a Chicago options research firm, says impulsive traders who were taken in by the high level of volatility last year placed big bets and got burned. Now they're shedding their option contracts, further depressing the market. Options market maker Botta Capital Management LLC has shelled out less than a third of what it paid for options last year to keep inventory low. "In a nutshell, there are no buyers," says Kevin Leahy, a Botta risk manager.

There's more: SSB's Gross says a record $50 billion in new zero-coupon convertible securities has dominated new equity issuance this year. Convertibles are bonds that can be turned into company stock at a preset price, invariably much higher than the current prices. By issuing such securities, companies are betting their stocks won't rise anytime soon. But hedge funds, brokerages, and traders have gobbled up convertibles and sold the issuers' stock short, forcing the markets yet lower.

The controversial Regulation Fair Disclosure may have hampered volatility, too. The Securities & Exchange Commission's rule bars companies leaking earnings to Wall Street, leveling the field for all investors. A new study says the rule has improved the flow of information to investors and made price reactions to earnings news less volatile: "One or two examples like a volatile Cisco remains in your memory," says K.R. Subramanyam, a professor at the University of Southern California and the study's co-author. "But if you go and study 1,600 firms, you understand the truth. Reg FD has dampened volatility."

Most investors don't want the stock market to be any rockier than it is now. But a few good bumps in the road might do a world of good for options. By Mara Der Hovanesian in New York, with Pallavi Gogoi in Chicago